Market coverage is prone to exaggeration, but the sell-off on Italian bond on Tuesday was truly amazing. Short-term bonds, which can normally be considered close substitutes for cash, became toxic and bondholders were in serious panic. Prices fell and yields on short-dated bonds rose more or more as the euro battled for survival in 201
The reaction in other markets was subdued by comparison. Sure, stocks and the miserable end of European sovereign bonds were sold, and there was a flight into the safety of US Treasurys. But that was not much more than a bad day. Portugal's 2-year bond yields rose 0.23 percentage points and Spain's 0.12 percentage points, both the worst since the beginning of last year. The 10-year US Treasury had its best day in almost two years amid a flight to safety.
In contrast, Italian 2-year bonds had by far the worst day since at least 1989, when Thomson Reuters data began. The return increased by more than 1.5 percentage points to 2.4% at the end of the European hours, with subsequent sale.
There are three possible interpretations of why markets outside of Italy are no longer sold out. The first is fundamental: the weak European economies have changed as they were threatened by Greece's contagion in the last euro crisis. Ireland is now considered a safe "heartland", Spain is growing fast and even Portugal has taken over medicine. Maybe this time the trouble is contained.
The second aspect is technical: the absence of any significant contagion is due to investors viewing the Italian train as exaggerated elsewhere, the result of hedge funds and others selling on a market offering bonds has suddenly become illiquid , Buyers fell by the wayside because an overcrowded market may continue to overshoot in the short term, but bond yields do not reflect the real risks to Italy.
The third is the most disturbing. Perhaps investors are complacent about the dangers that Italy poses and rely on the European elite once again finding a way to keep the brave politicians under control, as they have done so often over the past decade.
Italian bonds are cheaper (have a higher yield) because they fear that the country will rewrite its euro bonds in depreciated lira, the default of them or both, as was the case for Greece in 2011. Greece, of course, continued to default on its bonds and, in short, use capital controls to suspend the convertibility of its euros into the Euros used in the rest of the region, while no other country is following suit.
It is true that Europe's weak countries – Bar Italy – are not as weak as they were in the last crisis. Banks have been recapitalised or restructured, competitiveness has improved and current account deficits have become surpluses. Ireland, Portugal and Spain are all much stronger than they were. Italy has meanwhile burned out; as Chairman of Capital Economics
Every other country in the region except Italy has become more competitive with Germany since 2011.
In addition, Europe has the habit of making the impossible possible at the last minute and offering fiscal and finally monetary bailouts despite the recent crisis they were previously considered impossible and possibly illegal.
However, it is difficult to see how the common currency could survive an Italian exit without other countries following it. The country is the world's third largest borrower with $ 2 trillion ($ 2.33 trillion) of outstanding bonds and bills. Much of its debt is domestically, but the sheer size of the Italian debt stock means catastrophic failure for both its own and European banks. It would also create political breaches that could threaten the European Union, ironically for an organization founded by the Treaty of Rome.
The economic chaos in Italy after devaluation would be almost guaranteed and would certainly affect growth in the rest of Europe – although such chaos might convince the hesitant euro members that the pain of staying is worthwhile. It would be even worse from the perspective of the markets, if the Italian euro exit would go well and would encourage the anti-Europeans in other countries to repeat.
More convincing is the notion that Italy's bond market is exaggerating the panic because it has become so difficult to trade. The gap between the return people were prepared to buy and sell the two-year bond was unusually wide, 0.46 percentage points, according to Tradeweb. As a hedge fund manager shorting Italian bonds said there was a "buyer strike" because foreigners were unwilling to buy while domestic investors reduced their holdings.
The problem with the technical explanation based on liquidity is that it could go both ways. When buyers come back and the return drops, all is well and good. But often the first panic-stricken step on the markets turns out to be right after a period of consolidation. If speculators rightly see the danger that the newly installed technocratic government will quickly be replaced by anti-EU populists, these high or higher bond yields could well be justified. That will be the true test of contagion.
Write to James Mackintosh at [email protected]